Panel Detail:

Monday, April 23, 2007
10:15 AM - 11:30 AM

Moderator:

Jonathan Spalter, Chairman and CEO, Public Insight LP

Panelists (from left) Marc Lasry, Jon Lukomnik, Robert Matza and Paul Roth discuss potential new regulations facing hedge funds.

Not surprisingly, the Securities and Exchange Commission has maintained an interest in regulating the sector, but attempts have been overturned by an appellate court. In Europe, meanwhile, hedge funds are getting negative attention and press -- The Financial Times, for example, has published articles with such titles as "The Cancer of Hedge Funds" -- and are subject to some limitations.

Moderator Jonathan Spalter of Public Insight asked panelists whether "the industry needs more red tape."

Paul Roth of Schulte Roth & Zabel listed several possible reasons for regulating hedge funds: growth; systemic risk; the impact on trading markets; investor protection; and potential fraud. While systemic risk is an important issue, he argued, it should be the concern of the Federal Reserve, not SEC. Investor protection would be the most salient motivation for regulation among all possible reasons.

The discussion revolved around leverage and investor protection. Marc Lasry of Avenue Capital Group noted that the reason for the failures of LTCM and Amaranth was excessive leverage. LTCM was 50 times leveraged when it went down, he noted. Today most of the market operates at two to three times leverage, which means the industry is much less risky than it is popularly perceived. It should also be remembered, he said, that investors themselves can be levered, hinting at possible implications of regulation at the client level --"it all comes down to leverage." If the leverage is in the order of 10 times, the fund can easily go out of business. "If it’s in the order of two or three," he said, "that’s good."

Robert Matza of GoldenTree Asset Management, noted that the overall leverage in the market today is just a fraction of the level a decade ago and that not all funds exploit all forms of leverage. For instance, Matza's firm does not use prime brokerage leverage. Paul Roth agreed and added that today there are more tools at the disposal of managers and clients to deal with issues of leverage.

In terms of investor protection, Lasry emphasized that there is "already self-policing in the industry." If a fund does not perform well, it will have a difficult time keeping and attracting investors. Matza drew attention to the monitoring and disciplining roles brokerage firms play in the industry. Prime brokerages keep hedge fund assets, see their composition and performance, and can issue calls whenever necessary. He argued that a great deal of protection is built into the system in this fashion. Lasry expanded this line, providing the example of Bear Stearns, which will ask for more capital "at the smallest downtick." And rating agencies are watching like a hawk as part of the checks and balances in the system.

One needs to distinguish between funds investing in equities and those investing in bonds, advised Roth. A more interesting and more necessary distinction must be made between institutional hedge funds, around 350 in number, and those consisting of "two guys in a garage," he said. The latter are much more numerous, in the order of 10,000-12,000, and are not nearly as sophisticated as the former.

The new SEC rule of 2004 requiring hedge fund registration was overturned by the D.C. Circuit Court in 2006. The next step by the SEC would not involve an appeal, but an approach using alternative ways of regulating. Roth suggested that the target could be counterparty regulation addressing the ways investors and others do business with hedge funds.

Lasry noted that it's a fairly simple procedure to register with the SEC, and that sizable and reputable clients like CALpers value registration Thus, it's in the interest of serious fund managers to register. Jon Lukomnik of Sinclair Capital added that "it's great that pension funds are coming in since they discipline the market."

Lukomnik also said that the "idea that hedge funds are separate from the rest of the market is fallacious." He is especially bothered by "techniques to divorce economic interest from ownership interest." In his opinion, the whole basis of corporate governance is that marriage. He emphasized that a hedge fund is simply a legal construct -- but that the legal side has not caught up with the development of investment instruments.

There is bipartisan consensus in the Senate, but not the House, for regulation, explained Roth, adding that what happens at the state level remains a wildcard.

The panel concluded with general agreement that the industry will continue to "be attacked" and will eventually undergo regulation, not the least because of political motivations. The question remains, though, whether that regulation will be "smart."

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